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By Ronald P. Bernardi

Stockton, California emerged from Chapter 9 on October 30, 2014 when U. S. Bankruptcy Judge Christopher M. Klein confirmed Stockton’s plan. Detroit, Michigan emerged from bankruptcy on November 7, 2014 when U.S. Bankruptcy Judge Steven Rhodes confirmed Detroit’s plan. Both judges ruled each plan as presented is fair and feasible to all parties involved. There are clear winners and losers as a result of these decisions. And much remains unresolved with many unanswered questions.

The facts of rough justice in Detroit and Stockton

As we wrote in our April 15, market commentary Detroit settles with UTGO creditors, there is a rough justice in bankruptcy. These two settlements confirm that sentiment. Here are a few facts surrounding the settlements.

Detroit settlement facts:

  • Detroit will pay companies insuring voter approved unlimited tax full faith and credit general obligation (UTGO) bonds 74% of the outstanding principal and interest. This settlement is significantly higher than Detroit’s initial offer of approximately 10%-12%. The insurance companies negotiated this settlement and have stated they will pay investors 100% of principal and interest payments.
  • Detroit will pay limited tax general obligation (LTGO) bondholders 34% of the outstanding principal and interest. This settlement is higher than the city’s initial 10%-12% proposal as well. The insurance companies insuring a portion of the LTGO debt have stated insured investors will receive 100% of promised payments. Detroit will exact a 66% haircut on investors of its uninsured LTGO bonds and the insurance companies.
  • Detroit’ s approved plan does not haircut water and sewer revenue bond debt.
  • Detroit will haircut all other NON-BOND debt investments approximately 88% – 90%, as it originally offered.
  • City pensioners’ benefits were impaired with maximum cuts of less than 5%; cost of living increases were eliminated or reduced depending on retiree class. Health benefits paid for by city were reduced significantly. Pre-bankruptcy, pension liabilities represented approximately seven times more than general obligation bond liabilities.
  • Detroit has paid approximately $135 million in bankruptcy fees.

Stockton settlement facts:

  • Stockton will pay investor Franklin Advisors a 12% recovery rate when a $4 million secured claim is included, according to Judge Klein. Franklin states its recovery rate is only 1% on its $33 million investment in Stockton’s bonds. Judge Klein approved the city’s proposed payout over Franklin’s objections. These lease rental revenue bonds were issued to make improvements to city parks and golf course.
  • Insurance companies and Stockton negotiated a settlement months ago on other debt with insurers taking significant haircuts. The insuring companies have stated investors in these issues will receive 100% of promised payments.
  • Judge Klein confirmed Stockton’s treatment of pension payments to CalPERS — pensions are not reduced either retroactively or prospectively. In an earlier ruling, Judge Klein stated Stockton was free to abrogate its contracts with CalPERS while in bankruptcy and that CalPERS is an unsecured creditor. He stated federal bankruptcy law preempts state law and therefore CalPERS’ lien claim as a legal basis to assess Stockton a $1.6 billion termination fee was invalid in bankruptcy. Stockton did not pursue a CalPERS haircut in its plan making these findings moot because Judge Klein did not go beyond Stockton’s request.
  • Stockton did exact some labor concessions including reducing employee salaries and the elimination of most retiree health benefits.
  • According to Stockton, it has spent approximately $13 million on bankruptcy-associated fees.

Let’s review some observations and takeaways.

No guarantees for bond investors

There are no guarantees for bond investors. Lending capital to municipal issuers entails a degree of risk. This is why thorough credit analysis of an issuer’s finances is critically important in assessing the risk of a municipal bond investment. One must examine an issuer’s underlying credit quality, deal purpose and deal structure in order to find the many quality municipal bond credits. However, a central question — “Are voter approved full faith and credit UTGO bonds secured?” — was never put before Judge Rhodes for consideration because companies insuring UTGO bonds settled with Detroit. Investors and market participants need clarity on this issue and it remains unanswered in the aftermath of the Detroit and Stockton Chapter 9 odysseys. This is disappointing to us. The absence of clarity on this question allowed Detroit to extract a cash windfall from this creditor class. This settlement is not a legal precedent since it was negotiated. The facts, however, are not lost on other stressed Michigan municipalities (and their attorneys). Detroit’s plan is now their practical precedent.

Our takeaway: Until this question is answered by a judge or addressed by the state legislature similar to Rhode Island’s legislation, we continue to warily view investing in many UTGO and LTGO Michigan bonds.

Pensions treated much more favorably than debt holders

Pension creditors’ interests are treated much more favorably than those of debt investors. In both cases, local leaders decided to push plans favoring retirees over all other creditors. In both cases, each judge decided not to intervene — they chose not to alter the proposed plans and spread losses more proportionally based on each creditor class’ relative exposure. Judge Rhodes stated Detroit’s “discrimination in favor of the pension claims in the plan is necessary to its mission” and “the discrimination is not unfair” and the plan “is a model”. He also noted that while his ruling found federal bankruptcy law trumps Michigan’s protection for pensions, Michigan’s voters approved a constitutional amendment to protect pensions and the vote is “entitled to substantial difference”. That is his justification for accepting the city’s plan of better treatment of pensioners compared to other creditors, including bond investors. Similarly, in the Stockton case, Judge Klein chose not to challenge Stockton’s plan that left pension payments unaltered even though he had ruled earlier these pension payments were NOT inviolable.

Our takeaway: Creditors should not expect a federal bankruptcy judge to overrule or amend a Chapter 9 plan haggled over for many months. Both plans discriminated between creditor classes and neither judge altered any terms. Settlements or the filed plan determined recoveries in both cases, not a judge’s decision. Most major creditors settled rather than litigating to the end. Creditors that did not settle saw each judge approve the plan presented by the filing city. In future cases, each creditor class should negotiate a settlement they feel is fair to their interests and, if one is not agreed to, they should litigate to the end. This approach will force the presiding federal bankruptcy judge to address important and unanswered questions. San Bernardino, CA is currently in Chapter 9 and has indicated, contrary to Stockton’s plan, that it is willing to explore possibly reducing payments to CalPERS. If it files a plan cutting pension payments, given Judge Klein’s ruling on this issue, it will be difficult for the judge to sidestep the question. The case will be interesting to watch.

Everything is negotiable in Chapter 9

Certain debt structures are more secure than others, so a waterfall recovery is somewhat applicable. This is why insurance companies were able to limit their haircut to 24% on Detroit’s UTGO bonds while Franklin Advisors is stuck with an approximate 90% haircut on Stockton’s lease revenue bonds. The former has a much sounder security structure than the latter so the companies insuring Detroit’s UTGO bonds had more leverage. Detroit understood this and quickly upped its initial 10% payout offer to 74% and happily pocketed the difference.

Our takeaway: Chapter 9 is very complicated. Solid deal structure is always important, especially in these distressed situations.

Bond insurance’s value is confirmed

At this point, the value of bond insurance is confirmed. The insurance companies have stated they will pay 100% of debt service payments to all insured debt investors. This is good news. These companies negotiated strenuously with Detroit and cut deals in their best interests. In the process, the interests of other parties were affected.

Our takeaway: In Chapter 9, insurers act as a unifying force and are motivated to maximize their recoveries. Many debt investors benefit from their negotiating strength. Insurance company interests are aligned with the interests of insured debt investors, but not necessarily all debt investors.

Key questions went unanswered in Detroit

Questions surrounding security of Detroit’s water and sewer revenue debt went unanswered. Non-tendering investors will not take any haircut. Detroit tried to foist changes on this group even though the city’s utility backs this debt and is not in bankruptcy. Detroit pulled back from its initial position due to lack of leverage (see above) and decided not to force the issue. It has been resolved for the time being.

Our takeaway: Detroit blinked because it realized its legal standing was shaky. Non-tendering debt holders were resolute in believing their investments were secured and chose not to agree to any impairment.

Significant pension liabilities remain

Stockton preserved pensions entirely and Detroit reduced its pension liabilities minimally. Liabilities will continue to represent significant portions of the respective operating budgets post-bankruptcy. For example, Stockton’s 2020 budget estimates pension payments will absorb 20% of the year’s expected revenues. How will they deal with this fiscal reality?

Our takeaway: Will post-bankrupt Detroit and Stockton be able to make these pension fund payments each year?

Pensions viewed superior to other creditors

Both submitted plans demonstrated local politicians view pensions as superior to all other creditors. It was an easier decision for them to subordinate the interests of bond investors to pensioners demonstrating municipal bankruptcy is an inherently political process. We believe state law and state politics greatly influences Chapter 9 dynamics and therefore, these factors are key to determining final outcomes in these situations. For example, it is not possible to file municipal bankruptcy in certain states, difficult to file in many others and relatively easy in yet another group of states. Some states’ law view bonded debt as a statutory lien, while others do not. Some state legislatures have passed laws that place elevated importance on honoring local municipal general obligation debt. These are important distinctions especially in the case of a financially distressed municipality. We believe, therefore, differing state laws and differing state dynamics will lead to varied outcomes of future distressed municipality situations across the country. We factor this view into our credit analysis process.

Our takeaway: Our federalist system promotes competition between states. This is one of the most dynamic and foremost features of our system of government. States are “laboratories of democracy”, wrote Chief Justice Louis D. Brandeis. Good ideas crowd out bad ideas and investment capital moves across state lines easily. It will be interesting to watch if the flow of investment capital is altered or adjusts in any meaningful way by the resolutions of these two bankruptcies. It will be interesting to see if certain “good ideas” become standard fare in future incidents of Chapter 9.

Please contact us if you have any questions. We thank you for your continued confidence.

Sincerely,
Ronald P. Bernardi
President and CEO
Bernardi Securities, Inc.
November 12, 2014

Sources:

  1. Bloomberg News
  2. Summary of Oral Opinion on the Record in Re City of Detroit Bankruptcy, Judge Steven Rhodes, November 7, 2014
  3. Oral Opinion of The Record in Re City of Detroit Bankruptcy, Judge Steven Rhodes, November 7,2014